Understanding Derivatives Investing

It Sounds Complicated, and Can Be Risky, So Understand Derivatives

Oct 23, 2009

Derivatives are investments that have received a lot of attention in recent years, yet most people don't know much about them.

Over the past few years, derivatives have received attention as a somewhat exotic investment option for sophisticated traders. Now, however, derivatives are beginning to show up in many ordinary bond funds as a mechanism for increasing yield. That’s fine, when it works. But the use of derivatives also increases risk. Therefore bond investors need to know whether funds they are investing in are putting assets into derivatives.

What Exactly Are Derivatives?

First, let’s explain what we’re talking about. Derivatives are financial contracts designed to create pure price exposure to an underlying commodity, asset, rate, index or event. In general they do not involve the exchange or transfer of principal or title. So investors don’t actually buy anything. Rather their purpose is to capture, in the form of value changes, some underlying price change or event. The term derivative refers to how the price of these contracts is “derived” from the price of some underlying security, commodity, index, interest rate or exchange rate. Examples of derivatives include futures, forwards, options and swaps.

Derivatives can play an important role in hedging and managing risk, but they also pose several dangers to the stability of financial markets and the overall economy. Some derivatives can even be used for unproductive purposes such as the avoidance of taxation or the manipulation of accounting rules.

A Long History

Still, derivatives have been around for thousands of years. Derivatives contracts have been found written on clay tablets from Mesopotamia that date to 1750 B.C. And Aristotle made mention of an option on the use of olive oil presses 2,500 years ago.

Today the issue is not olive oil, but the fact that more and more mutual funds and exchange traded funds are including derivatives in their asset mix. When these derivatives increase yield it can be very appealing to baby boomers who are looking to boost their retirement nest egg.

There Is Significant Risk

But that extra yield has a downside risk. It limits the upside potential of the fund if stocks for which the options are written go up. If that happens, the fund is at risk of losing the stock if it rises above the strike price of the call.

And financial professionals warn that derivatives are complicated and that even many fund managers may not understand them sufficiently to be using them wisely. Some derivatives are relatively low risk, such as U.S. Treasury futures. But others carry greater potential for volatility. An investor should know whether a fund they have a position in is investing in derivatives. It may not be a bad thing, but it does increase risk. And any time one is exposed to increased risk they should know about it.

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